Fixed Annuities vs. Variable Annuities
For most people, the word “annuity” might as well be a four-letter word. When I talk about them in my practice, I find that there is a very negative connotation associated with them. Yet most people’s understanding of annuities is very limited at best. So, I wanted to take some time to explain what they are and go over some of the different kinds of annuities. I think most people will realize that they are not quite the monster they have been made out to be.
What Exactly is an Annuity?
According to Webster’s Dictionary, an annuity is an insurance policy or investment that pays someone a fixed amount of money each year. While that is one potential function of an annuity, there is so much more explaining needed to understand what an annuity is, and what it is not. Annuities are insurance contracts, but whether they pay out money each year is up to you. Webster’s definition is describing an immediate annuity, not a deferred annuity.
A deferred annuity will allow you to defer the payment of income until you wish to start taking it. This allows you to defer the taxes associated with those earnings until you are ready to take the income. When asked about the secret to attaining his great wealth, Rockefeller replied, “One of the secrets to my great wealth is I only pay taxes on the money I spend.” This is a new line of thinking for CD and bond owners who are used to paying the taxes each year, even if they reinvest all of the interest they are paid. Any money not paid in taxes allows for compounding of interest on money that would have otherwise been paid to the government.
Annuities have a specified length at issue, much like a CD that says you must leave the money in the policy for a certain number of years. The time frame can range from one year all the way to 16 years, depending on the insurance company issuing them and the level of guarantees provided when you sign up. And just like a CD, there can be penalties for withdrawing too much of the money too early. However, most annuities allow a 10% free withdrawal. This means that if you had $100,000 on deposit, you could take up to $10,000 that year with no penalty associated. A traditional CD will not allow this, and it will begin charging a penalty immediately.
Some annuities offer a bonus for signing up, which is a pretty unique feature in the insurance or investment worlds. An 8% bonus would simply mean that if you deposited $100,000 on day one, your account would have $108,000 in it. You would immediately begin earning interest on $108,000 vs. $100,000 like you would with any other investment or deposit. This can be an especially nice feature if you are looking for more income to supplement your Social Security or pension. It can give you a boost to your potential income now or sometime in the future.
Now that we have an idea of what an annuity is, let’s compare some of the different types that are available.
The most common misconception about annuities is that people think they are all the same. Wrong. Their differences are almost impossible to number. There are literally hundreds of different products available in the annuity market, and they are not created equally.
The first thing you should know about variable annuities is that your principal is NOT guaranteed. This makes it different from every other type on the planet; because the underlying investments are mutual funds, or “subaccounts”— the value cannot be guaranteed by the issuing insurance company. For those that don’t know, a mutual fund is simply a collection of stock, bonds and other similar asset classes whose value can vary on a daily basis. There are no guarantees on the value of a mutual fund, and that is why your deposit is not guaranteed or as it says on the front of the brochure, “May lose value.”
The other thing that is important to note about variable annuities is that the fees that are associated with them are the highest in the industry. A fee structure on a variable annuity might look something like this:
- Mortality and Expense: 1.25%
- Administration Fee: 0.15%
- Subaccount Fee: 1.15%
- Income Rider Fee: 1.25%
So let’s see, that is a total expense load of 3.80%. That means that if your underlying investment performs at 5% in a given year, they will credit your account with 1.2%. Ouch. This is the main reason I discourage the use of variable annuities. An investor can buy most of the available subaccounts of a variable annuity in a mutual fund on the open market for just the 1.15% if they choose and avoid all the other fees. The expense load of a variable annuity in many cases can prevent the client from achieving their goals. In fact, SEC says it is NEVER suitable to purchase a variable annuity, and have extensively warned consumers about the potential hazards of purchasing these products.
When people see annuities in a negative light, it is generally because they have experience in dealing with variable annuities.
Multi-Year Guarantee Annuities
This is a type of fixed annuity. This annuity means your principal is 100% guaranteed by the issuing company and the state guaranty fund. While annuities are not FDIC insured, they are backed by the state guaranty fund for $100,000 per account per insurance company. In some states, this can be as much as $250,000. This is a fund all the insurance companies that do business in a given state must contribute to, and it backs up your deposit very similarly to the FDIC program.
A multi-year guarantee annuity (MYGA), gives a specified rate of interest over a specified period of time. This interest rate is guaranteed and will not change for the life of the contract. Rates on MYGAs tend to be much higher than CDs because of the underlying investment. An example of a MYGA might be a five-year guarantee of 3% per year. Similarly, a five-year CD might pay 1.75%. Both are very safe and predictable investments. However, neither provides the potential for higher rates of return.
There are generally no fees associated with MYGAs, with few exceptions, and owners still get the benefit of deferring taxes until the money is taken out.
Hybrid annuities, or “fixed indexed annuities,” combine the potential for higher returns of a variable annuity with the principal protection and lower fees of a MYGA. These annuities are also the most likely to offer a bonus up front for purchasing one. Bonuses range from 2% to 12% depending on which insurance company’s product you choose, and the length of the contract.
With this type of annuity, the money is measured against a stock index such as the S&P 500. If the S&P 500 is down for a given year, the worst you can do is make 0%. You can never lose money with these annuities. If the index is up, you will participate in a percentage of the gain dictated by what type of strategy you use. Using an uncapped strategy, meaning they put no limit on how much you can gain in a given year, these types of annuities can produce consistent returns of 4-7% with no risk to your principal, along with the benefit of deferring the taxes on interest earned in the account.
These accounts have many optional features that may or may not be right for you, such as enhanced death benefit or income riders. These riders are available for a fee, and can enhance the parts of your policy that are important to you. Even though there is a fee associated, the total fee for most of these policies with riders on them is 0.40% to 0.95% per year, much less than the variable annuity.
People that like to have flexibility and more options tend to like these annuities the best.
This article should give you a little better idea about the different types of annuities, and how they can benefit a potential buyer. As I said, all annuities are not created equal, and you should probably consult a professional that has access to all of the types of annuities, as well as other investments, so you can be sure to get objective advice. Annuities are not right for everyone, but for many it can provide a balanced approach to retirement and better guarantees for a portion of your portfolio.
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